The New Compensation Committee Responsibilities–
A Roadmap For Meeting The New Standards And Avoiding Personal Liability

PART II: Steps Eight Through Twelve

As promised, the following is a continuation of our May-June issue setting forth guidance for compensation committees. [Note that, for ease of reference, we have posted an electronic version of this issue on CompensationStandards.com that contains direct links to the practice pointers and materials referred to in this issue. And, for those who may have missed it, we have also posted an electronic version of the May-June issue, setting forth the first seven steps.] Before resuming at Step Eight, a few follow-ups are in order.

Feedback
First, we would like to thank our readers for all the positive feedback we have received. A few representative comments from respected colleagues: "Although you laid out some pretty strong medicine, you seem to have struck a chord." "Many clients have been sending us underlined portions of the issue seeking our guidance on implementation." "With all the blue ribbon reports out there, your issue appears to be the catalyst that is causing clients to act."

Personal Liability/D&O Insurance
Some readers pointed out to us that, even though Section 145 of the Delaware General Corporation Law prohibits companies from indemnifying an officer or director unless the person acted in "good faith," Section 145(g), on the face of it, permits companies to purchase D&O insurance, notwithstanding bad faith. It was pointed out, however, that in some cases the D&O coverage might not be sufficient to cover a director’s entire exposure. It was also brought to our attention that the SEC recently adopted a policy requiring settling parties to forgo any rights they may have to indemnification or reimbursement by insurers. Query: Could courts take a similar position? [This and other important issues relating to directors’ exposure to personal liability in the compensation context will be addressed in an important session with Professor Charles Elson and past and current Delaware Supreme Court Chief Justices Norman Veasey and Myron Steele at our upcoming October 20 Major Compensation Conference.]

SERPs, Severance and Change in Control — And Tallying It All Up
The largest number of comments were centered around our coverage of the "stealth" components of compensation. Many readers praised the practice pointers we have now posted on CompensationStandards.com which focus on the red flags and important considerations that directors need to be aware of when reviewing or approving non-qualified deferred compensation, SERPs, severance and change in control arrangements — and the importance of tallying it all up. [Many readers asked us for model tally sheets for compensation committees. At our request, task force members have already begun to submit tally sheets which we will continue to post on the website.]

Step Eight: Surveys, Benchmarking and Peer Groups —
Misleading the Compensation Committee (and Shareholders)
The common practice when reviewing a CEO’s compensation is to refer to executive compensation surveys. Unfortunately, as compensation consultants now readily acknowledge, surveys are not just flawed and biased (see Fred Cook’s excellent article on this topic, "Compensation Surveys are Biased," posted on CompensationStandards.com), they can be massaged and cherry picked to come up with  pre-ordained results that a CEO has either explicitly requested or that the consultant has derived to ingratiate him/herself with the client. The consultant might deliver a report to the compensation committee with an incongruent pair of "peer" companies: one set for purposes of executive compensation and another for corporate performance. [As a respected colleague has pointed out to us, "A real issue here is who is the client. It may be easy for the consultant to lose sight of the fact that his ‘client’ is the compensation committee, acting on behalf of the company, not the executives."]

In executive compensation surveys, it is easy to inflate numbers by including extraordinary or one-time payments and grants, or by relying on surveys conducted for other companies that included such items. This reliance might even be unintentional. On top of all this, as more companies adopted the practice of "benchmarking" — taking the position that their above-average CEO should be paid in the top 25th percentile of all CEOs — a slippery slope resulted. Compounded each year, benchmarking quickly became an out-of-control ratcheting-up phenomenon that resulted in exponential growth in compensation, as this year’s top 25th  percentile becomes next year’s 50th, requiring another increase to get back into the top 25th, and so on.

Another problem is that these surveys often do not take into account that some companies may put greater emphasis on cash compensation than stock options, while other companies may place greater emphasis on long-term incentives. By cherry picking from each category, a CEO can have his cake and eat it too.

All of this can help largely explain how at some companies CEO salary and bonus and stock grants and other components of CEO compensation have gotten so far out of line — not just from the median workforce salaries generally, but also from other senior and mid-level executive compensation at the CEO’s own company.

It still is troubling that many compensation consultants, who acknowledge how surveys have brought CEO compensation into the stratosphere, still use those inflated survey numbers — that have years of compounded inflated numbers built into them — to help clients determine what is the appropriate level of salary, bonus and other compensation. This continues to perpetuate all the mistakes of the past. Going to a 50th percentile now — which may have been last year’s 25th percentile and which would have been off the charts just a few years earlier — is not reform.

[Compensation committees cannot afford to ignore the admonitions about surveys in recent governance reports: "The committee should resist an over-reliance on surveys and other statistical analyses in determining compensation levels." (Business Roundtable) "So-called market-based compensation. . .is a root cause of the current problem." (NACD Blue Ribbon Commission) "Percentile benchmarking should not ever be practiced except to provide broad market reference points." (Breeden Report)]

Step Nine: Directors Must Take Charge and Reassess, Modify,
and Even Roll Back, Years of Built-In Excesses
The reality remains that compensation consultants, lawyers and other advisors are still paid by the company and can ill afford to alienate the CEO. Even where an advisor is retained separately by the board or compensation committee, the reality is that boards and committees include CEOs of other companies that don’t want to hear that their compensation also has to be rolled back. And even newly retained consultants often are reluctant to (or can’t afford to) jeopardize their relationships right off the bat with, e.g., company counsel and other esteemed advisors that have been present while all this has been going on.

But the buck must stop somewhere. And it is becoming increasingly clear that all eyes are now fixed on the directors who comprise the compensation committee. As a result, it will no longer be sufficient for directors to blindly accept survey numbers. Instead, each board has an obligation to analyze its CEO compensation going all the way back to when divergences with the rest of the workforce began — which for many companies will mean having to analyze the CEO’s total compensation going back to the early 1980s. Several surveys have demonstrated the divergences. An excellent article that explains how we got to where we are now — which should be basic reading for every director and every advisor — is the Fortune magazine piece by Geoffrey Colvin entitled "The Great CEO Pay Heist". For more thought provoking suggestions for compensation committees assessing CEO pay, see the articles just posted on CompensationStandards.com entitled "Excessive Executive Compensation: A New Test For Director Liability" and "How Much Pay For How Much Performance?"

As one major consulting firm points out, one reason why boards may not have realized just how far CEO compensation has skyrocketed is that decisions on various compensation components are made at different meetings, thus making it more challenging to tie all the components together and comprehend them. The result has been loading up on all the available components of compensation, instead of being selective.

As directors start to conduct the hard analysis, it will come out at a number of companies that not only has the cash compensation and the stock compensation gotten way out of line internally from the company’s starting point back in the 1980s, but that the heretofore inadequately understood and undisclosed components — when now added to the cash and stock compensation — take the true numbers farther out of line, leading to the inescapable conclusion that rollbacks may be the only corrective solution.

[One corrective approach that we like is what we call the "internal pay equity check" — following the Dupont and Intel models of checking for "internal pay equity" at various levels within a company to ensure that the CEO’s compensation has not gotten out of line within the company. As stated above, compensation committees should direct their H.R. people to provide a comparison chart that goes back to the 1980s (when the gaps began to get out of line) comparing the gaps in compensation levels within the company between the CEO and NEOs and senior and mid-level executives, down to the rank and file (and including all components of compensation, e.g., SERPs and perks and accumulated option and restricted stock gains, etc.) as a framework to bring the CEO’s (and, in some cases, NEOs’) total compensation back in line.]

Step 10: And So Many Other Things To Address
This next step is the hard one — how to correct the past excesses of many yesteryears. In some cases, adjustments and rollbacks will be the only solution. After-the-fact rationalizing could lead to cover-ups and more personal exposure. While in the process of "auditing" and rectifying your current CEO (and NEO) compensation, the following should not be overlooked:

How Can We Take Back and Modify Existing Grants?
Fortunately, there should be ample opportunity for compensation committees to change and renegotiate a past practice. These opportunities exist each time any aspect or component of a CEO’s compensation is considered. For example, to be awarded a new option or restricted stock grant, the CEO could agree to fixes to past and outstanding awards. This could be accomplished by rollbacks or new retention provisions that require the executive to hold the stock until retirement.

After tallying up the compensation components, if a compensation committee finds it has been paying a lot more than it realized, hopefully that fact alone will be enough to motivate a CEO to agree to changes — rather than face the embarrassment of public disclosure of the excesses in the compensation committee report in the next proxy statement and a disclosure that the CEO refused to agree to meaningful adjustments.

One challenge with roll-backs is that many CEO contracts provide for a severance payment for termination without cause or if the CEO walks for "good reason." Good reason typically is defined to include any diminution of salary or other benefits. As a result, a CEO could easily say, "I won’t agree to a rollback and you can’t make me or I walk and receive a big payout."

Here is one respected colleague’s response: "But the court in Disney made it pointedly clear [at pgs 29-32 of the opinion] that the executive has a fiduciary duty here as well. Query whether a committee could bootstrap that into some leverage: ‘We think you, Mr. Executive, have a fiduciary duty to the company and its shareholders to be sure that the package was fair and appropriately authorized and if you don’t cooperate with our re-examination under a review that applies the proper process and asks the right questions, we think you are breaching your fiduciary duty, and therefore providing a basis for us to terminate you, Mr. Executive.’ In other words, the executive may have a self-interest in having the committee re-evaluate the existing compensation arrangements and defending the pay by being able to show that the committee had thoroughly considered it."

[See the excellent Task Force piece posted on CompensationStandards.com that provides practical guidance regarding how to deal with excessive CEO compensation, "Taking From The King: The Mutual Need and Practical Tips for Rolling Back or Modifying Excessive CEO Compensation."]

Converting Options to Restricted Stock or RSUs:
The Obligation to Reassess Underlying Grants — And Other Concerns
Compensation committees that have been converting outstanding options to restricted stock or RSUs may be overlooking an important obligation. A grant of restricted stock or RSUs is a new grant. This means the compensation committee has a more fundamental obligation than just deciding on the proper percentage to apply to the conversion. The committee can’t just rubber stamp what was already granted. If it turns out — by today’s more conscientious standards — those past option grants (particularly mega-grants) would now be considered excessive, then this new grant should be reduced, particularly now that the grant should be viewed in the context of the CEO’s total compensation and not as an isolated component. We are concerned that quite a few companies have not focused on this and may be vulnerable unless they make adjustments to those new grants.

Another troubling aspect of the rush to restricted stock at some companies is the failure to attach any meaningful performance conditions. Query: Would directors be so quick to grant restricted stock if they viewed it as essentially handing cash to an executive to buy company stock (which can be kept — no matter how the executive performs — simply by hanging on with the company for a few years). And worse, the vesting period often is accelerated under various scenarios, as several of our Task Force submissions point out. In addition, restricted stock generally does not qualify under the 162(m) one million dollar cap.

[It would be interesting to see whether compensation committee minutes covering the approval of simple time-vested restricted stock grants address the absence of performance risk, or reflect any discussion of the cost to the company of the lost tax deductions for amounts granted to top executives exceeding the $1 million cap — and whether the proxy statements of those companies that recently have made large restricted stock grants to replace outstanding options have included any discussion or rationalization in their 162(m) proxy statement disclosure (or compensation committee report) or have just included the same old boilerplate — leaving directors vulnerable.]

Stock Grants to CEOs and NEOs: The Need to Calculate Total Accumulated Gains —
And Hold Until Retirement
Although stock options, restricted stock and other similar types of equity are classified as long-term incentive compensation, most recipients treat the cash from selling these shares more in the nature of bonuses or windfalls to be capitalized on when the stock price is up. At least for CEOs and NEOs — particularly where total accumulated stock option and restricted stock gains are substantial — it is time to view stock compensation as solely a long-term vehicle. [Indeed, some consultants have shared with us their concern that accumulated option and restricted stock gains are not being factored into current compensation decisions at many companies.]

This means that, at a minimum, the compensation committee should seriously consider whether top executives should be required to hold the after-tax portion of these shares until retirement so that the executive truly has a long-term incentive. To avoid unintended effects (e.g., encourage early retirement), retention provisions can provide for something like "the shares must be held after exercise or vesting for the longer of __ years (the difference between the person’s then age and age 65) or retirement." Compensation committees can take a major positive step by implementing a hold-til-retirement policy for CEOs and NEOs, particularly with respect to large outstanding awards. [Remember our colleague’s suggestion, above, on the CEO’s fiduciary self interest in agreeing to modifying existing grants. CEOs (and boards) may find that, in some instances, adding a retirement retention requirement could be a sufficient and more palatable fix than a rollback. Note also the possible application of such an approach to addressing the problems with recent conversions from options to restricted stock, raised above.]

The List Goes On: Contracts, Double-Triggers, Three Times Salary and Bonus,
162(m) Violations and Inadequate/Misleading Disclosures
Contracts. As covered in the NASPP’s March webcast, "What the Compensation Consultants are NOW Telling Compensation Committees" (archived at Naspp.com), the NACD Blue Ribbon Report (at pg 48), and our Task Force pointers, long-term and automatically renewing employment contracts are becoming increasingly disfavored and should be seriously reconsidered, generally avoided and, where possible, eliminated. The very nature of a long-term or evergreen contract ties a company to an executive — for better or worse — and may require the company to choose between letting the executive go (i.e., non-renewal of the contract), with the incurrence of a hefty severance payment, or continuing with a less-than-average executive.

It is clear that a company that does have a long-term employment contract with its CEO has an affirmative obligation to consider its automatic renewal. The recent case of Pereira v. Cogan, 294 B.R. 449 (S.D.N.Y. 2003), decided by a district judge applying Delaware law, found directors of a privately-held company to have abdicated their fiduciary responsibility when they failed even to consider the automatic renewal of a CEO’s long-term employment agreement, without a review of the CEO’s performance and the continuing appropriateness of the terms of agreement. The bottom line here is to avoid evergreens where possible, but if you have one, you still must fulfill your fiduciary obligations.

Note also that companies should carefully review the definition of "cause" in employment contracts, possibly adding such elements as cooperation with governmental investigations (this has never been more important than in today’s environment, given the recent $25 million Lucent penalty for its lack of cooperation and the just updated Federal Sentencing Guidelines, which take into consideration corporate cooperation; not to mention a growing SEC Enforcement Staff and the birth of the PCAOB) or fraudulent CEO/CFO certifications under Section 302 or 906 of Sarbanes-Oxley. It would be inequitable if the company is required to pay the executive severance or a lucrative lifetime pension when the executive is fired because of fraud or other securities violations.

Hand in hand with refining the definition of "cause" is the need to add to all outstanding agreements (including options and restricted stock agreements) for CEOs and NEOs a clawback in the event of restatements or other harmful actions by the CEO/NEO to the employer — even where there has been no fraud or certification claim. (See our Task Force pointers regarding "cause" provisions and clawbacks.)

Note that in those instances where contracts cannot be avoided, the negotiation process is paramount. Consultants and independent counsel can help ensure that the compensation committee engages in real negotiation with the executive over the pay package contained in an employment contract. Without a real analysis and negotiation (and without fresh reviews of outstanding contracts — including running projections annually of payouts under various scenarios), the plaintiffs’ bar will have a field day.

Double—Triggers, Severance Formulas. In addition, severance and golden parachute provisions that only have a single trigger (i.e., awards become vested upon a change in control) need to be re-examined to assess whether there should be a double trigger (e.g., awards become vested only after a change in control and termination in connection with the change in control). The practice of providing single-trigger acceleration was driven by accounting considerations that are now largely obsolete. In light of today’s market, there is no compelling reason to provide the "windfall" of accelerated vesting. Where a double-trigger acceleration is used, severance is paid out only in the event of termination of employment. The plan will need to provide detail about what constitutes a qualifying termination for accelerated vesting, such as being fired without "cause" or resigning for "good reason."

Further, as many responsible critics have pointed out, the practice of using 3x salary as a severance formula needs to be re-examined and cut back to reasonable levels. In a recent letter to CalPERS from the California State Treasurer, it was noted that "[f]ederal law places a steep excise tax on ‘excessive’ golden parachutes, those that provide more than three years of compensation. But what federal law set as a ceiling has become a floor for golden parachutes." The Treasurer went on to request that CalPERS put in place a "model severance policy that more closely ties payouts to shareholders’ interests." Providing more than one year’s base salary to a departed executive (and adding bonuses — which are supposed to be incentives that are earned — to the formula) is out of step in today’s world, especially when taking into account the CEO’s other payments, including SERPs, vesting accelerators and the size of accumulated equity gains. (See the helpful Task Force submissions addressing potential severance pitfalls and the need to run all the numbers resulting from payments from different overlapping components that can be triggered by termination of employment.)

162(m) Violations. The IRS is wrapping up an executive compensation audit pilot program in which it found Section 162(m) violations surprisingly common among the two dozen large-cap companies that it audited. As a result, we understand that the IRS has targeted 162(m) non-compliance as a focus area for future audits. As our readers know, Section 162(m) disallows a public company’s deductions for compensation in excess of $1 million per year for its CEO and its next four highest-paid officers unless the compensation meets the requirements for "performance-based compensation" paid under shareholder-approved plans.

Common 162(m) compliance problems include: options granted under a non-shareholder approved plan; restricted stock (or restricted stock units), where neither the award nor the vesting is tied to objective, pre-established performance criteria; failure by the compensation committee to certify in writing prior to payment that the performance goals have been satisfied; or failure to timely set the performance goals — e.g., not set within the first 90 days of a one-year performance period.

To avoid these 162(m) violations, it is imperative that the members of the compensation committee understand 162(m) and its technical requirements. Further, a company’s human resources staff should consult and coordinate with both the chairman of the compensation committee and the company’s compensation consultant, if any, so that the staff acts as a backstop for compliance — and compensation decisions are not made in a vacuum.

Moreover, as is true for much of the compensation committee report, it appears that quite a few companies simply regurgitate boilerplate language about 162(m) compliance in their proxy statements each year, putting directors as well as those responsible for internal controls at risk for regulatory actions — and providing additional fodder for plaintiffs’ lawyers. The boilerplate disclosure can be particularly problematic if a company is sitting on a Section 162(m) violation. Compensation committees should make sure that, in addition to setting forth the company’s policy on Section 162(m), companies are, in fact, disclosing what they are actually doing in practice, including the actual costs the company is incurring where there is non-compliance. [See the excellent Task Force submissions providing 162(m) pointers and red flags for compensation committees, including a 162(m) checklist for compensation committees.]

Step 11: The Art of Minute-Taking — The Plaintiffs’ Bar is Watching
Recent complaints in executive compensation lawsuits remind us of the importance of proper minute-taking. Under recent innovative uses of the books and records provisions of Delaware law, it is now easier for plaintiffs (as well as those pursuing "just vote no" campaigns against incumbent directors) to access board and committee minutes. Complaints filed in executive compensation lawsuits quote heavily from minutes and, just as importantly, note what is not in the minutes (see the April 20, Stanziale v. Nachtomi decision from the U.S. District Court in Delaware).

Although many companies have traditionally followed the school of thought that board minutes should be "bare-boned," the tide appears to have changed in the past few years and now many practitioners believe that boards should take care to provide sufficient detail in their minutes to reflect more clearly what transpired. It is not that the minutes need to be so detailed as to reflect what each particular director said — but they should state that discussions took place (as opposed to merely noting that a specific action was approved). This might be important if a government investigation or lawsuit ensues — but also will assist independent auditors, underwriters and any others that need to conduct due diligence.

In fact, for compensation decisions that are considered major corporate actions, it might even make sense to have a litigation-savvy lawyer draft the minutes. Remember that boards and board committees have the authority to hire their own counsel — and this may be an appropriate role for such counsel.

Recent cases that have challenged board or committee actions have faulted the corporate record left behind, preventing directors from establishing that they have met a duty of care or good faith (e.g., the specific reference in the Disney opinion that only one and one-half pages of the minutes covered the approval of Mr. Ovitz’s contract).

In short, minutes should include a description of each major item acted on, including a summary of the item, the major issues presented, the major factors taken into account — or relied upon — by the board, the board’s decision and, in appropriate cases, the alternatives considered.

Based on the complaint filed against Cendant, those drafting compensation committee minutes may also want to address:

• The use of outside advisors and the extent of their involvement

• Complete explanations about how any pay formulas, caps or other thresholds were derived

• The reliance on spreadsheets and analyses regarding the pay package

• Any material changes to the pay package as originally presented, including the rationale for those changes

• The calculation of what the entire executive pay package could amount to — and the financial impact that payout would have on the company

• The calculation of what termination pay could amount to — and the financial impact that payout would have on the company

• The minutes should reflect that questions were asked throughout the meeting (if true — and it should be true!)

• If members of the committee were involved in negotiations with executives over pay packages (as they should be), their participation should be noted in the minutes by having them report to the committee